Trading Losses Depress Anadarko Petroleum's Profits

• The Company: Anadarko Petroleum, an oil and natural gas company with operations in Algeria and the United States.
• The Filing: Form 10-Q filed with the SEC on August 6, 2008.
• The Finding: Despite record energy prices in the second-quarter, Anadarko said its net income for the three-months ended June 30 fell 98 percent to $23 million, due to $1.6 billion in derivative losses.

The Upshot: Volatile energy prices coupled with $1.2 billion in capital expenditures in the second-quarter, primarily for drilling and development opportunities, dictated the need for predictable cash flow. Through the use of derivative instruments, such as swaps and options, the company sought “to lock-in” prices for forward delivery, ensuring sufficient cash flow.

The company received prices (excluding derivatives), on average, of $9.88 per thousand cubic feet for natural gas and $117.63 per barrel of crude for delivery in the United States, up almost 61 percent and 64 percent in price, respectively, year-on-year.

Unfortunately, by hedging against falling prices, Anadarko traded away, on average, $0.58 per thousand feet of cubic feet and $85.80 per barrel in potential gains for natural gas and oil, respectively, in the second-quarter of 2008.

Fortunately, the losses were recorded as “unrealized losses,” for no monies actually changed hands — as the contracts were for forward delivery (GAAP accounting rules). This explains why discretionary cash flow from continuing operations in the second quarter was $438 million.

Anadarko was not alone in making the wrong bet in the price direction of oil and gas. Natural gas producer Chesapeake Energy and Noble Energy – among others — recently posted losses of $1.6 billion and $716 million, respectively , in (unrealized) hedge trades.

The Question: If oil and gas companies control the prices of fuel commodities — as their critics allege — how come they cannot correctly predict price directions?